Spend any time on the internet and you can be inundated with advertisements for debt consolidation loans. These advertisements claim the loans save you thousands of dollars in interest and lower your payments giving much needed relief for your budget. While it's true consolidation turns multiple payments into one payment that could save you money, there are potential dangers associated with these loans. Here are the pros and cons of consolidation loans to help you make informed decisions regarding your finances.
Debt Consolidation Basics
Many financial advisors downplay consolidation loans because they only address the symptom of the problem. While consolidating addresses the debt and gives you a plan for repaying, the spending habits that created the debt are not addressed. Consolidation may help you finally pay off those high interest credit cards but if left unchecked, you'll spend your way right back into debt six months later.
The pros of consolidating debt seem great on paper. You can often get a lower interest rate on at least part of the credit card debt and get a lower monthly payment. But one of the potential dangers of choosing the wrong consolidation loan is that you're getting the lower payment not because the interest rate is going down, but because the term length is longer. This means you're going to stay in debt for a longer time and have to pay more interest to the lender for the extra years on the loan's term. So while the lower payment can ease your cash flow issues, in the long-term you could be paying more than what you already owe, eating up any "savings" you may seem to get.
Debt Consolidation Companies Make Money From You
Consolidation companies like to claim they're helping people get out of debt, but what's in it for them? It's true they will consolidate all of your high interest credit cards and unsecured debt into one payment. They might even give you a decent interest rate. But, suppose you're consolidating $40,000 in debt at 9% interest. Over six years it's going to cost you just over $46,000 for the "convenience" of the lower payment.
Still, you might be okay with paying six grand for a little breathing room in your budget. If consolidation does actually lower your total payments and eases your situation, it may still be worth considering, but just remember consolidation is treating the symptom, not the cause of your financial problem.
Change Your Spending Habits First
If credit cards are your kryptonite, debt consolidation is not going to be the solution to your financial problems. Unless you address the behavior that led to your debt problems you could find yourself paying the consolidation loan and credit card bills from new purchases.
Paying cash for purchases is a good strategy for avoiding credit card debt. Cut up your cards and if you feel the need to keep one for "emergencies" try keeping it in a block of ice in your freezer. You'll not be tempted to make frivolous purchases when the credit card is locked up in a five pound block of ice.
Consolidation loans can be a useful tool for improving your finances when used responsibly. Remember these loans only address the symptoms of your debt problems and not the behaviors that caused them. Without first addressing these behaviors debt consolidation loans are merely a bandage to a much larger problem.